The Market Seems Unwilling To Let Yum! Brands Stay Cheap For Long

When I last wrote on Yum! Brands (NYSE:YUM) in early February, I thought the shares were cheap relative to the long-term value but likely wouldn't stay cheap for very long. With the shares already up 10% since then, it looks like that call is working out. It's true that the news from the company's large China operations remains weak, but I believe the worst has passed and the company still has a global growth story to drive the stock.

China Is Still Bad, But Maybe Not As Bad As Feared
China has been a major source of growth and profits for Yum! Brands for quite some time now, but that growth has gone sharply the other way lately on a one-two punch of supplier quality problems and the avian flu. While I don't want to soft-peddle this development, I think it's hasty to assume that the company's KFC brand has really lost any real long-term value in this huge market.

True, sales have taken another step to the worse. Same-store sales were down 20% in the first quarter and down 13% in March, and now they've dropped again in April – down a whopping 29%. This time it seems like the culprit is an outbreak of bird flu that has been spreading through China. Although it may seem strange or silly over here, it's nevertheless true that chicken demand plunges there during outbreaks of bird flu (even though there's no documented cases of transmission of flu through chicken meat).

The good news, such as it is, is that the same-store sales drop for the first quarter wasn't quite as bad as feared for margins. Restaurant margins in China did fall about seven points in the first quarter (about 30%), but this wasn't as bad as feared and the better margins there fueled about 60% of the company's eight-cent operating beat relative to analyst estimates. Now I don't know that the company can keep this up indefinitely, but management deserves credit for preserving margins as well as they have.

How Much Damage Has Been Done To The KFC Brand?
The bigger question for Yum! Brands shareholders for the long-term is how much damage has been done to the KFC brand from the contaminated chicken scandal that fueled the first quarter sales decline (and that is probably still impacting sales to some extent).

Chinese TV and social media were pretty relentless in discussing the story, but at no point did it appear that Yum! Brands knowingly participated in buying chicken that was contaminated with antibiotics. Moreover, management has been active in trying to get the word out to customers that they have changed suppliers and made changes to their policies to help prevent this from happening again.

I think a few other points are worth mentioning. Although Yum! Brands took the brunt of this scandal, they weren't the only restaurant impacted – McDonald's (NYSE:MCD) and some local chains were involved as well. What's more, the overall health of the Chinese restaurant market may not be so great – Country Style Cooking (NYSE:CCSC) saw same-store sales decline in the low single-digits, and fears tied to the avian flu could keep more diners home and away from public gathering places. I think it's also worth mentioning that restaurants like McDonald's and Yum! Brands' KFC and Pizza Hut aren't priced as value offerings in China, and tougher economic times can hit them harder.

With that in mind, I'm not buying the story on Bloomberg Monday morning that Yum!'s KFC brand is in trouble in China. Certainly the company will need to refresh and refurbish its stores at some point – that's true for every restaurant, and there's no reason that this company will be exempt. It's also true that the company is going to have to be careful to manage it's menu. But given the skill with which Yum! Brands management has handled its brands in China so far, I need to see more data before I believe there are real long-term problems here.

The Bottom Line
I haven't changed much in my outlook regarding Yum! Brands. I'm still looking for revenue growth in the neighborhood of 6% and free cash flow (FCF) growth in the low double-digits, with a resulting fair value close to $70.

With the stock having rebounded back to that level, I'm more ambivalent about adding shares right now. True, Yum! Brands is now one of the only quality consumer brands to be trading at a reasonable price relative to its fair value, but it also has arguably the most risk right now. I'd consider picking up shares on a rebound back into the mid-$60, as I do believe this is still a very solid long-term story at the right price.

At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.